With Friends Like Japan Who Needs Acne?

From Nic Lenoir of ICAP

If you were worried about the Portuguese auction tomorrow fear not! Japan decided to be proactive fighting this latest break-out of European sovereign CDS rates and extend a very unselfish hand. Indeed how could one doubt their good intentions? All they want is to make sure their currency stops appreciating in order to keep the youth unenployment rate in Italy around 29%. Following China's lead Japan announced they would buy European bonds. With only 200% debt to GDP ratio it makes sense for them to go ahead and chip in to help Portugal throw bad money after an even worse structural issue. China gets relatively little bad press for supporting European markets as conventional wisdom assumes their official 20% debt to GDP ratio is accurate. Other analysts much better informed on the subject than I am, in fact some even created a fund dedicated to benefit from when China's economic miracle is exposed for the ponzi scheme it is, claim actual numbers are much closer to 120% but the people's republic uses all sorts of accounting trickery and local government vehicles to disguise the true extent of its indebtedness. Japan however shall not benefit from the general public's stupidity with debt levels well publicized. Indeed as we discussed many times before, Japan's public debt is astronomical. To date they were able to keep growing their debt because they started their lost quarter century with a savings rate around 8%. That savings rate is now negative which means Japan will at some point in the future, when exactly is anyone's guess, will have to rely on foreign demand to finance their debt. Now I don't know for you, but if US Treasuries are considered toxic by a lot of fund managers out there, how many people do you really think will line up to buy 10Y JGBs yielding 1.18%? Obviously Japan's announcement had not so much to do with their desire to rescue Portuguese finances, but instead is aimed in my opinion to the obvious secondary effect of weakening the JPY. That will work to temporarily slow down the fall of EURJPY, but when it comes to USDJPY it is exclusively driven by the 2Y UST/JGB rate spread. So if Japan really wants to weaken the Yen they might as well start dumping their 2Y treasuries. With the time interval between solvency crises shrinking exponentially as the eventual end game approaches, I have my doubts as to how much good will come from this touching display of Eurasian brotherly love. Perhaps is this why the Dollar index refuses to trade South this morning...

All this should however be supportive of our 10s/30s steepener recommendation. The market appears to be stalling a little bit here but the trade moved 14bps already and I expect at least another 10 from it. Another similar trade that was brought to my attention by a friend and wise trader is the 2Y-forward 2/10 steepener. While this trade has not traded as well as the 10s/30s the last week, it has a uge advantage when it comes to positive roll: the 2s/10s curve trades around 272bps spot, and 146bps 2Y forward. That means approximately 5bps of positive roll in your pocket each month. We are trading still slightly above the key trend support which comes around 130bps (see chart). While it would the ideal level to get the trade on, it might worth adding into the trades on pull-backs as the very positive roll makes the opportunity cost of being greedy more expensive.

Directionally to me 10Y Treasury futures, bond futures, or bund futures, all look like they are shaping a consolidation in the form of a bear flag before making new lows. The Bund has a big resistance area around 1.2691/1.2705, meanwhile the equivalent level for the 10Y UST future looks like 121-09/121-14. At these levels I will consider expressing shorts, especially in light of the fact that a Fixed Income sell-off would likely cause our 10s30s to retrace some of our gains temporarily.

As far as equities go the chart looks like a manipulated market that no one wants in. Dismal volumes despite all the bullish revisions of forecasts indicate that the P/E ratio of 12 is not enough to entice that many people to jump in. Perhaps is it because investors realize that the entire US GDP itself is fabricated by monetary stimulus and that without it those earnings are in no way sustainable? Record earnings are driven by a modest recovery in sales (see attached chart) coming at a very expensive public cost, and a lot of cost-cutting that will further burden the public deficit via the cost of social programs. If you thought earnings could drop by over 50% in just a snap if the monetary experiments end, why would pay more than 12 times "artificial" earnings? In any case, volume speaks louder than words, and it seems that to date the US stock market has failed to really convince many investors. Thank God for those first day of the month and POMO-induced cash injections!

Good luck trading,